The economics of money, banking, and financial institutions (11th edition) by f s mishkin ch18 the foreign exchange market

Foreign Exchange Market• Exchange rate: price of one currency in terms of another • Foreign exchange market: the financial market where exchange rates are determined • Spot transaction

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Chapter 18The Foreign Exchange Market

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• This chapter outlines how the foreign

exchange market functions and how the value of different currencies is determined.

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Learning Objectives

• Explain how the foreign exchange market

works and why exchange rates are importance.

• Identify the main factors that affect exchange rates in the long run.

• Draw the demand and supply curves for

foreign exchange market and interpret the

equilibrium in the market for foreign exchange

• List and illustrate the factors that affect the

exchange rates in the short run.

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Foreign Exchange Market

• Exchange rate: price of one currency in

terms of another

• Foreign exchange market: the financial

market where exchange rates are determined

• Spot transaction: immediate (two-day)

exchange of bank deposits

– Spot exchange rate

• Forward transaction: the exchange of bank

deposits at some specified future date

– Forward exchange rate

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Foreign Exchange Market

• Appreciation: a currency rises in value

relative to another currency

• Depreciation: a currency falls in value

relative to another currency

• When a country’s currency appreciates, the country’s goods become more expensive to foreigners and foreign goods in that country become less expensive to domestic economic agents.

• Over-the-counter market mainly banks

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Figure 1 Exchange Rates, 1990– 2014

Source: Federal Reserve Bank of St Louis, FRED database: http://research.stlouisfed.org/fred2/.

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Exchange Rates in the Long Run

• Law of one price

• Theory of Purchasing Power Parity

assumptions:

– All goods are identical in both countries

– Trade barriers and transportation costs are low – Many goods and services are not traded across borders

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Figure 2 Purchasing Power Parity, United

States/United Kingdom, 1973–2014 (Index: March 1973 = 100.)

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Factors That Affect Exchange Rates

in the Long Run

• Relative price levels

• Trade barriers

• Preferences for domestic versus foreign

goods

• Productivity

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Summary Table 1 Factors That Affect Exchange Rates in the Long Run

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• Supply curve for domestic assets

– Assume amount of domestic assets is fixed

(supply curve is vertical)

• Demand curve for domestic assets

– Most important determinant is the relative

expected return of domestic assets – At lower current values of the dollar (everything else equal), the quantity demanded of dollar

assets is higher

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Figure 3 Equilibrium in the Foreign Exchange Market

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Explaining Changes in Exchange Rates

• Shifts in the demand for domestic assets

– Domestic interest rate

– Foreign interest rate

– Expected future exchange rate

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Figure 4 Response to an Increase in

the Domestic Interest Rate, i D

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Figure 5 Response to an Increase in

the Foreign Interest Rate, i F

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Figure 6 Response to an Increase in the

Expected Future Exchange Rate, E e

t+1

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Summary Table 2 Factors That

Shift the Demand Curve for

Domestic Assets and Affect the

Exchange Rate

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Application: Effects of Changes in Interest Rates on the Equilibrium Exchange Rate

• Changes in Interest Rates

– When domestic real interest rates raise, the

domestic currency appreciates.

– When domestic interest rates rise due to an

expected increase in inflation, the domestic currency depreciates.

• Changes in the Money Supply

– A higher domestic money supply causes the

domestic currency to depreciate

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Figure 7 Effect of a Rise in the Domestic Interest

Rate as a Result of an Increase in Expected Inflation

Step 1 A rise in the domestic real interest as a

result of an increase in expected inflation shifts the demand curve to the left

Step 2 leading to a fall in the exchange rate.

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Application: Why are Exchange

Rates So Volatile?

• The volatility of exchange rates is due, in part, to the fact that they are based on unstable expectations regarding an

uncertain future.

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• Our model of exchange rate determination

helps explain the rise in the dollar in the early 1980s and fall thereafter.

– a rise in the U.S real interest rate raises the relative expected return on dollar assets, which leads to

purchases of dollar assets that raise the exchange rate

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Figure 8 Value of the Dollar and Interest Rates, 1973–2014

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Application: The Global Financial

Crisis and the Dollar

• During 2007 interest rates fell in the United States and remained unchanged in Europe

• The dollar depreciated

• Starting in the summer of 2008 interest

rates fell in Europe.

• Increased demand for U.S Treasuries

“flight to quality”

• The dollar appreciated

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Appendix: The Interest Parity

Condition

• Comparing Expected Returns on Domestic and Foreign Assets

– Since the vast majority of real world transactions

in currency markets involve economic agents buying and selling currencies based on their value as assets, one must develop an

understanding of how these assets are valued.

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Condition

• From the perspective of an American

economic agent, the expected return on

dollar-denominated assets is equal to the domestic rate of interest.

• For a foreign economic agent, Francois the Foreigner, the expected return on dollar-

denominated assets is equal to the rate of interest associated with those same assets, adjusted for an expected appreciation or

depreciation in the value of the U.S dollar relative to the Euro.

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Condition

• If foreign and American bank deposits can be

considered perfect substitutes for one another and capital mobility exists, then parity should exist

between the interest rate on dollar-denominated bank deposits and the interest rate on Euro-

denominated bank deposits.

• This notion is summarized in the following equation.

• This equation is known as the interest parity

condition.

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